Question

what is the Role of Derivatives in the recent Financial Crisis? with details

Answer 1

Derivatives are the instruments whose values are derived from the value of the underlying assets. While several derivatives such as call option, put option, futures etc are relatively easier to understand and hence trade into, there are many more derivatives that are structurally very complicated and complex. Such derivatives are mortgage based securities (MBS), collateralized debt obligations (CDOs), credit default swaps (CDS), to name a few. These were the derivatives that led to the recent financial crisis of 2007 - 09.

Roles played by Derivatives in the recent crisis:

1. Added to complexities of the existing derivatives markets: Investment bankers introduced many such derivatives in the market that were not understood by many participants. Markets then could not understand the depth and complications of MBS, CDOs. Valuations were difficult to do and very complicated.
2. Default on the underlying assets of these derivatives: When interest rates started rising, many of the home buyers (and specially those under floating rate / adjustable rate mortgage) were not able to service the debt. They started defaulting. These mortgages were the underlying assets for MBS. As a derivative derives its value from that of its underlying asset, a drop in the value of houses led to significant drop in the value of MBS. This led to a global meltdown.
3. When interest rates started rising, the ability of the home buyers to service debt started decreasing. The demand for houses fell. So did the prices. So, the market value of the assets fell. They were already over leveraged. Fall in market prices of the underlying asset led to margin call all over and wiping out of the values of the MBS.
4. Further, these derivatives markets were unregulated by the Securities and Exchange Commission. Practically there were no regulation and no governance. There were no rules.Since there was no support from the government, fall of one Lehman Brother led to unprecedented panic in the financial markets. This further fueled the crisis.